Hold on during sharemarket big dipper

By Annette Sampson

8 November 2008 — 12:00am

I've been trekking in the Himalayas. Don't worry, this isn't a travel tale but it does explain why I'm feeling like Alice through the looking glass. When we left, things weren't looking too hot. Markets were in a tizz over the collapse of more US investment banks and the realisation was hitting home hard that a global recession was inevitable.

It wasn't pretty but all indications were that investors would come to terms with the grim outlook.

I returned to find the world had gone mad. Either that or some cosmic slipstream had picked me up from the Annapurnas and dumped me into an alternate reality.

Not having experienced the panic that led to such extreme measures as the Government being forced to guarantee bank deposits and the Australian dollar plummeting to US60c (now that hurt), it is difficult to conceive how things got so bad so quickly. Some people had even written off the entire capitalist system.

Just what causes mass markets to move from nervousness and pessimism to panicked hysteria has fascinated many researchers but there are still no concrete explanations. What is known is that capitulation - that widespread belief that things will never get better, that we're stuck on an eternal downward spiral - is an integral stage of the investment cycle.

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In recent decades, many investors have come to believe that market falls are buying opportunities. Shares down 10 per cent? You beauty, it's time to snap up some bargains. Down another 5 per cent? Let's buy more.

And it has worked. Because we've been in a long-term bull market, this thinking has paid off handsomely. Even major blips, such as the tech wreck earlier this decade, have only dampened the money-making run.

But capitulation is the opposite of this. It's giving up. It's believing that things have so fundamentally changed that investing is no longer worth the angst. Rather than making money, you're just going to lose more. Capitulation doesn't come easily, especially after a long bull run. The behavioural finance experts (they're the people who study how investors do behave rather than how investors should behave in a rational market) talk about referencing. This is the natural human tendency to use recent experience to make decisions about the future.

So when the first bad news from the US subprime crisis came out, share values were quick to rebound. Last November, shares had reached new highs, even though most experts agreed the fallout would not be limited to US home lenders. In the new year, on news of bank failures and serious problems in the financial system, markets tanked again but investors were still not prepared to give up.

Whether we have now "done" capitulation or we are still to plumb those depths is uncertain. On the graph (right), which was put together by IPAC Securities this year, you'd have to say we are well past denial and have certainly experienced fear. There's been panic aplenty and the constant flow of bad news is making us increasingly inclined to expect the worst.

But we don't really capitulate until we have had so much bad news that we've forgotten what good news looks like. And, as the graph suggests, once we have capitulated we find it hard to accept better news when it comes.

History tells us that markets do recover. But it also tells us that where major structural adjustments are required, this can be a slow process. This is the most serious financial crisis since 1929 and the US Dow Jones Index took 25 years to regain its peak after that fall. (The Great Depression didn't help). The Japanese stock market has still to return to the peak it reached in the 1980s boom.

Governments and central banks are working overtime to minimise the impact of the current financial crisis on the broader economy. But more bad news is inevitable.

In that sense, it's easy to understand why the standard advice to "sit tight and ignore the bounces" can sound trite. It is. The global deleveraging taking place has changed the investment landscape and questions should be asked as to whether investments bought for the good times are still appropriate and whether your investments have the integrity to survive further storms.

Bear markets also remind investors that investing is not just about chasing profits. Having strategies in place to manage risk is a key part of long-term investing. And as investors in unlisted property trusts and mortgage funds have found out, liquidity is another important consideration.

But reviewing, adjusting and even rethinking your investment strategy is not the same as panicking. In some respects it was good to be sitting on the side of a mountain when the hysteria was at its worst. There was no temptation to dump good long-term investments and by the time I returned the damage had been done. It wasn't nice to see my investments had gone backwards - again - but at least I can make rational decisions for the future.